How The Pros Pick Growth Stocks

One day in the summer of 1979, Debra Joseph Diamond got a call from an institutional salesman for Rotan Mosle Inc., a regional brokerage firm based in Houston. Diamond, a small, dark-haired woman who was then only 26, was a vice-president and investment analyst with T. Rowe Price's group of mutual funds in Baltimore. Her job was to find health-care and medical-services firms for possible inclusion in TRP's New Horizons Fund portfolio, the group's small-company growth-stock entry in the mutual-fund market.

The Rotan Mosle salesman knew all this, and was calling to urge Diamond to follow up on a little-known stock being touted by a broker in his firm's New York City office. The company he was pushing was Key Pharmaceuticals Inc., a Miamibased enterprise with sales at the time of $13.5 million.

Reading up on the company, Diamond discovered that most of Key's sales reflected the success of a product called Theo-Dur, a treatment system for asthma. In the treatment of asthma with the drug theophylline, the range between potentially toxic overmedication and ineffective undermedication is narrow. TheoDur allows even, sustained release of the drug over a 12-hour period. Introduced in 1976, it had sold well.

Now Key was rolling out a Band-Aid-like nitroglycerin patch called Nitro-Dur for patients suffering from angina pectoris. Angina patients typically take nitroglycerin in pill form, which reduces its effectiveness, or in ointment form, applied to the skin. Nitro-Dur simplifies the latter process -- a patient can put a patch on the skin every 24 hours and forget about it -- and it apparently acts as a sort of prophylactic, relieving the anxiety that patients anticipating pain normally undergo.

In late summer 1979, Diamond went to New York, where along with some other analysts she had lunch with Key's management. Impressed with their presentation, she visited Key at its Miami headquarters. There, the president and chairman fielded her barrage of questions about strategy, finance, and products, and she took a tour of the facilities.

The company, she felt, was looking good. Key had evidently found a unique niche in the marketplace, with both of its major products promising to serve a large clientele. She thought well of the company's management and its research and development teams. Although Key was young, its president, Michael Jaharis Jr., had many years of experience with Miles Laboratory Inc., and understood the importance of marketing. His company stood on sound financial footing and was already profitable. And it didn't have any other institutional investors. These were all characteristics Diamond liked to see in a prospective purchase.

Back in Baltimore, Diamond worked with a calculator to determine whether Key, based on her projections, could achieve the 17% to 18% growth rate New Horizons's analysts use as a benchmark in evaluating possible acquisitions. Key passed with flying colors. In fact, it looked as if the company would grow 80% the next year.

Diamond's last step was to take advantage of contacts in the medical world made through her husband, a physician. She queried a cardiologist, a pulmonary specialist, and a pharmacologist at Baltimore's Johns Hopkins Hospital. She also called a dermatologist at Cleveland's University Hospital, and a director of pharmaceutical purchases for a chain of drugstores. Since Key's Theo-Dur met the professionals' approval and passed New Horizons's investment requirements, she recommended that the firm's investment advisory committee approve the stock for purchase. The committee was a little wary. The stock then cost about $10 a share, a price that was an astronomical 43 times earnings. Nevertheless, they agreed with Diamond about the company's prospects. By October, New Horizons owned 68,134 shares (including splits up to September 8, 1982) of Key Pharmaceuticals. For her part, Diamond was confident T. Rowe Price had just bought itself a gem.

Finding companies like Key Pharmaceuticals can be like looking for gold in a muddy stream. The process is time-consuming, the payoff is uncertain, and it is often hard to distinguish between real metal and less lucrative flashes in the pan. Most individual investors, moreover, have neither the time nor the resources to analyze companies as extensively as do pros like Diamond and her colleagues at T. Rowe Price.

Still, the work done by securities analysts provides a kind of touchstone by which one's own efforts can be measured. There is nothing stopping an individual from investigating one or two investment prospects as thoroughly as a professional investigates dozens. And in growth-stock investing as' in anything else, it never hurts to know how the experts go about their business.

Like a lot of individual investors, the analysts at TRP's New Horizons Fund get their tips from brokers, colleagues, and business contacts.

* During the dead equity market last spring, one of the fund's directors urged assistant vice-president and analyst Roger B. McNamee to look at Equatorial Communications Co. Equatorial had developed a satellite network for sending data through a two-foot-wide dish rather than through the standard three-meter dish, and the director happened to own a radio station that was a subcarrier in part of the system. When McNamee heard from a friend in the venture-capital business that the company looked good, he investigated, and eventually the fund bought the stock.

* Philip J. Rauch, a vice-president and analyst covering technology stocks for New Horizons, met with the management of a computer graphics company called Intergraph Corp. at a trade confer ence while the company was still private In 1981 after Intergraph had gone public New Horizons bought the stock at $10. Soon after it took off. After some ups and downs it was the fund's seventh-largest holding as of July of this year.

* Tim Ebright, vice-president and analyst handling the media and consumerservices sectors, discovered LIN Broadcasting Corp. in 1981 through an institutional database service provided by William O'Neil & Co. Ebright, a relative newcomer to the broadcasting and publishing fields at the time, screened the database for companies that fit certain criteria, and among those that fell out was LIN, a small, New York City-based television and radio broadcasting company. Ebright checked it out, and New Horizons bought that, too.

The methods analysts use in examining a portfolio prospect vary, both with the individual and with the industry. Most, like Diamond, study the usual range of financial and strategic fundamentals, but many add personal touches of their own. Rauch, for example, lists three unsurprising qualities he wants to see in company managements -- honesty, motivation, and ability -- and continues with some less predictable criteria. He doesn't want a chief executive officer to have a sloppy desk. He doesn't want to see Jaguars or Ferraris in the company parking lot, and he doesn't like reserved parking places. "Fancy corporate headquarters are a negative, too," he adds.

Instead of impressing me, it tells me that management probably spends more time with designers and architects than they do with the company."

Idiosyncrasies aside, all the analysts look for companies that are still early in their life cycles. Most successful small companies, they say, go through an "emerging" phase, when they are run in an entrepreneurial manner, and an acceleration" phase, when the company's market share is increasing and management evolves into a professional team. Buy and hold during the first phase and the first half of the second phase, the analysts advise, and begin easing out toward the end of the second. Most companies' rapid growth periods last only a few years -- four or five at the most. Not coincidentally, New Horizons's portfolio rolls over in about the same time period.

Being the first institutional investor to come upon a company is a sometimes unexpected bonus. A broker with a small Dallas-based firm -- Schneider, Bernet & Hickman Inc. -- clued Tim Ebright into a mail-order company called BSN Corp. back in early 1982. BSN markets sporting goods to schools and other institutions, undercutting its competitors by 30% to 50%, and in 1981 it was reporting sales of about $5 million. Ebright and Michael Blumenfeld, BSN's president, were equally surprised when Ebright visited the company. "My eyes split open when I walked in," Ebright recalls. "The president told me I was the first institutional analyst that had ever been there. I didn't know quite how to respond. I told him, 'That's wonderful, I love to hear that.' " New Horizons subsequently became the first large institutional buyer of BSN's stock, and Ebright expects others to follow. If they do, the stock is likely to rise.

Unlike a lot of investors, New Horizons' stock pickers get cautious whenever the initial public offering market heats up. About a year ago, the stock pickers point out, three or four prospectuses were appearing each day on the analysts' desks -- a message, in effect, that every other institutional analyst was looking at the same companies. "Many of the participants in the IPO market of 12 months ago who were flipping new issues -- buying them and then selling them three hours later for a 30% profit -- are now absent from the market," explains Tim Ebright. "I'd say about 70% to 80% of the newissues thatcame out 12 to 18 months ago are now under water. Those buyers who held onto the new issues are not real anxious to increase their exposure to a market when they were burned so recently."

Ebright and his colleagues are more interested in the less popular initial public offerings of the past six or seven months. It is more difficult for a company to find underwriters in this environment, he notes, so those that do go public are the companies with the best reputations. It is a company working policy that New Horizons analysts can buy up to 20% of an IPO.

After purchase, the analysts say, come the hardest jobs: recognizing mistakes and winnowing out the losers. Debra Diamond, for example, thought she had another hot prospect when she discovered National Medical Care Inc., a company that was successful in the kidney-dialysis business. In an attempt to diversify, National Medical Care was trying to develop an obesity-control program -- which, unlike some weight-loss programs, would be closely regulated by physicians and would hence be costly. However, this new area of business proved not as successful as Diamond expected it to be -- prospective patients were evidently unwilling to pay the high fees the program required -- and the growth rate of the kidney-dialysis business was slowing. As people began to leave the company, but before National Medical Care's profits suffered, New Horizons sold out at a profit.

Rarely, however, are the signs so easy to read. A couple of years ago, Ebright investigated a company called Anixter Bros., a distributor of electronic products, wire, and cable. To Ebright, Anixter seemed perfectly positioned for the impending American Telephone & Telegraph divestiture. The company had several Bell operating company executives on board and good relationships with suppliers. Due to the breakup of AT&T, Anixter's potential market came to some $12 billion. Believing that the company had a good chance to double its revenue base, despite some impending short-term problems, Ebright recommended purchase.

By the end of the first month, New Horizons owned 250,000 shares of Anixter, having paid in the low- to mid-20s for them. Then, as Ebright had expected, some of the company's business continued to drop off, and management predicted five or six more down quarters. All that, Ebright thought, had undoubtedly been reflected in the stock's price. As the quarters unfolded, however, he soon realized that the market was not prepared for what he thought it already knew, and the price fell.

Out of that experience came a useful rule of thumb. "We've taken some decent losses from that investment," Ebright observes. "We had to stop, sit back, and say, 'Let's forget the past. Looking at today's price, is Anixter Brothers a good investment?' We realized it was still a good investment. The stock hit a low recently. We bought more shares."

Some of the best stocks, of course, are those that the market doesn't care about at all. In early 1982, Ebright learned of National Education Corp., a firm that owns and manages trade and business schools across the country. Enrollment in National's schools was increasing dramatically as the unemployed flocked to sign up for its programs. Ebright liked the company: Not only was it doing good business, it was also using highly conservative accounting practices to counter some of the fast-and-loose-with-figures publicity that had plagued others in its business. But the stock was selling for only five times forward earnings, and Ebright hesitated to make an investment.

"I asked myself what I was missing, he says now. "But it turned out I wasn't missing anything. The market just did not care about this type of company." New Horizons made the investment, and, soon after, the market responded to the changes Ebright had already anticipated. "The stock turned out to be an excellent performer," he says.

If there is a time to buy and a time to hold, there is also a time to sell -- even when the going still looks good. Increased institutional ownership is one warning to small-company analysts that the time to get out is coming; and some say when 50% of a company is owned by institutional investors, it is an automatic sell signal. The logic is simple enough: These investors don't want to be caught with a stock that is likely to be sold abruptly by half its owners in the event of bad news. But there are other indications, too.

Debra Diamond, for example, was happy with Key Pharmaceuticals -- for a while. "Key did everything we thought they would and more," she says. "They were very successful with Theo-Dur, and within two years it became one of the largest selling drugs in the United States." Nitro-Dur also turned out to be a hit. By February 1983, Key Pharmaceuticals held the number three ranking in the fund, with upwards of 710,547 shares valued at nearly $24 million.

In 1983, the stock hit what would turn out to be its high to date, selling in the high 30s. Diamond thought that the stock had become overvalued relative to its prospects. The company was continuing to grow, but the rate of growth had to level off. "I thought it was unlikely Key would succeed as well a third time," Diamond remembers. "The company was getting much larger, and for it to continue at its present 80% revenue growth rate, a third product would have to generate $80 million in revenues right off the bat. How likely was that? Key's profit margin also looked like it had gone as high as it could go. I believed it would continue to be a growth company, but that the growth would be slower."

Once a company's growth rate slows, the stock's P/E usually tends to fall over time. Nor are profits helped when competitors enter the marketplace -- and Key's chief competitors were not other small drug companies but giants like Ciba-Geigy Corp. and G. D. Searle & Co. Finally, when New Horizons first bought Key Pharmaceutical, institutional ownership represented .3% of the stock. By 1983 that figure was up to 17.6%.

As if to validate Diamond's doubts, rumblings about the efficacy of Key's products started to be heard within the health-care community. Despite patiends' wide acceptance of the Nitro-Dur nitroglycerin patch, a study conducted at the University of Pennsylvania suggested that the length of medicinal effect provided by the nitroglycerin patches was insufficient. Rumor had it that the FDA was going to investigate the efficacy of Nitro-Dur. The stock looked vulnerable -- and now Diamond was seeing more negatives than positives.

The time to sell, she felt, came in June 1983. The stock was up, and the profits would be good. To hold on longer was risky. That month, the fund started selling Key, continuing to phase out its position through November. Adjusted for splits, the stock New Horizons bought cost only $1.92 a share. When the fund sold, it received anywhere from 16 2/3 to 25 1/2 a share.

Recently, Key has been selling between 12 and 14. Since last year, however, the heavy cloud surrounding Nitro-Dur has cleared; prescriptions of the product have never been higher. The company is also continuing to expand its product line with innovative drug-delivery systems. One new product in the pipeline, Allogen, promises to shorten the time period for allergy immunotherapy. And TheoDur is still the widest-selling bronchodilator in the country. Key's annual sales have jumped from $13.5 million in 1979 to $127.3 million in 1983.

Some brokers, in fact, are as wild about the stock as ever -- including Leroy Goldfarb, the Rotan Mosle broker in New York City who first touted Key's attractions back in 1979. "With a P/E these days of 10 to 11 times earnings, the stock simply sells itself," he bellows confidently. "You want to buy some? I'm still opening new accounts with Key."

Now that the darkness surrounding Key has lifted, will Diamond consider another buy recommendation? "I won't say I will . . . but I won't say I won't, either," she says cautiously.

SMALL-COMPANY MUTUAL FUNDS

Small-company stock earnings are typically expected to be twice those of the market in general, but the stocks are also more volatile than the market. So most mutual funds that specialize in small-company issues have dropped considerably over the past year, particularly by comparison with such broad-based averages as Standard & Poor's 500 Index. If the market turns up, however, the funds can be expected to rise correspondingly faster than the averages.

The five largest funds specializing in small-company stocks are listed below. % change in net asset value